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Wednesday, June 25, 2008

A Subtle Misconception About Futures Prices

Even many economists subscribe to the mistaken belief that the futures price at any moment represents "the market's" best guess about what the spot price will be on that future date. But this simply isn't true. If the July 30 futures price of oil is $138, that doesn't mean people in the oil business expect the spot price to be $138 on July 30. All it means is that the people going long and short in the futures contract can know that they will swap oil and money at that price. There is no corollary that their best guess is that the spot price will also be in that neighborhood.

(Actually, what I said is strictly true for a forward contract. A futures contract is marked to market periodically during its life, so that the spot and futures price really do converge at maturity. However, because their accounts will be credited or debited as spot prices move, the people exchanging the futures contract today can make their plans as if they will be exchanging oil for cash at $138 per barrel on July 30.)

Anywho, I think Arnold Kling makes this (understandable) mistake when he says:

"If oil prices are expected to decrease (backwardation)..." (From the fifth or so paragraph in this post.)

So Kling is here saying that if people in the oil market expect spot prices to fall over time, then this is the same thing as saying right now the futures price is lower than the spot price. This latter event is the definition of backwardation.

You can see the difference pretty easily: We can always check whether we are in backwardation, since it is a snapshot thing between spot prices right now and "the futures price" right now. But in order to see whether oil prices decrease over time, you would actually have to wait a few months and watch.